A top priority for policy makers considering financial reform should be addressing the “too-big-to-fail” issue, Federal Reserve chief Ben Bernanke said on Friday, suggesting five fronts policy makers should look at.
Policy makers should pay “especially close” attention to systemically important non-bank financial institutions, encourage long-term compensation policies, set framework for non-bank financial firms, improve the financial infrastructure and gain the capacity to wind down non-bank institutions in a safe way.
“The problem of too-big-to-fail is extremely serious,” he said today in Phoenix, Ariz. at the Independent Community Bankers of America's National Convention and Techworld.
1. Weaknesses at major financial firms
The first, which is already being done, he said, would be to address weaknesses at major financial institutions. This concerns capital adequacy, liquidity management, and risk management. Addressing this would not only serve to assure institutions’ safety and soundness but also to offset their incentive to grow until they are perceived too big to fail.
2. Compensation practices
Second would be to address compensation practices which can create “perverse incentives” that can harm the institution. Compensation policies should be aligned with the institution’s long-term interests, be tied to the institution’s risk, provide incentives for safe and sound behavior and avoiding short-term payments for transactions with long-term horizons.
3. Non-bank financial firms
Third would be to address the issue of financial firms outside the banking sector, he said. There should be a framework in place for all systemically important financial firms organized as holding companies, he said.
“Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors,” he said.
4. Improving financial infrastructure - or 'plumbing'
The fourth would be to improve the financial infrastructurewhich supports trading, payments, clearing and settlement activities. Those changes would reduce the chance that one institutions’ failure would have spillover effects on others or the broader markets.
5. Orderly resolution of non-bank firms
Lastly he said that the United States needs to develop an improved resolution regime that is similar to what is in place already for insured depository institutions. This would reduce the 'too-big-to-fail' problem by giving the government the option of safely winding down an institution if necessary, rather than keeping it operating.